Inflation Targeting in Albania
Mimi KODHELI
“Pushing inflation too low-say, below to 5 percent- may entail a loss of output and seigniorage revenue, suggesting a need for caution in setting very low inflation targets in low-income countries. These countries tend to be subject to larger output volatility and more pronounced price shocks, and program design should take these attributes properly into account. In particular, inflation targets should be set so as to help avoid risks of an unintended concretionary policy stance.”
IMF (2006), pg 17
Economics Department - University of Verona
Polo Didattico Giorgio Zanotto
Viale dell'Università, 4
37129 - Verona - Italy
1. Albanian macroeconomic environment, features and indicators
Albania has made substation progress since the beginning of the transition in 1991. Unlike some former Soviet Union and CEE countries that started the liberalization of the economy in the ‘80s (like Hungary e.g.), Albania did not undertake any pre-transition reform before 1991.
During 1991-1992 the economy experienced sharp decline in output and high levels of unemployment and inflation. The economic situation led to a mass migration of the world abroad, especially to Italy and Greece.
Recovering from the pyramid schemes crises of 1997, Albanian economy continued to experience high positive growth rates. Between 1998 and 2006 real GDP has averaged almost 6 percent annually (Fig.1).
Inflation record has also been impressive, varying not far from 3 percent target of the central bank in more than 8 years now (Fig. 2).
The vigorous growth led to an estimated GDP/capita of almost US 3,000 in 2006 upgrading Albania to the group of middle income countries (Fig.3).
Fig.1 Real GDP growth 1996-’06 (in %)-Source: INSTAT (Albanian Institute of Statistic)
Fig. 2 Inflation-annual average 2001-‘07 (in %)-Source: INSTAT
Fig.3 GDP/capita in USD-Source: INSTAT
The initial rapid speed of growth was mainly observed in those sectors of the economy where market liberalization proceeded quickly like services and agriculture. Despite the initial revitalization of agriculture, lack of investments, land fragmentation and absence of proper land market, land property problems, poor infrastructure reduction market access, and weak food processing capacity, led to a slowdown in agriculture growth to around 3 percent per annum. As aresult its share to GDP narrowed to 21 percent from its high 35 percent in 1996 (Fig.4). However, it still remains the main source of income for nearly 40 percent of the population.
Fig.4 Contribution to GDP by sectors 1996-2005 -Source: INSTAT
In the last ten years sectors like construction and services have been the major contributors to Albanian growth.Services sector is one of the most dynamic sectors of the Albanian economy, constantly providing a high contribution to the economic activity and growth of the country. The weight of this sector to the economy has been increasing, recording a trend expected to continue even in the future.
The assessment of performance of this sector is based on the sales index of economic enterprises by services items in wholesale and retail market, hotel and restaurant services, telecommunication and other services. Revenues generated from sales of these services have increased constantly during latest years and currently constitute about 60 percent of overall revenues of economic enterprises.
Construction emerged as key sector in sustaining growth, compensating for the agriculture and industry oscillation.During latest years construction has turned out to be one of the main pillars of the Albanian economy, because of its weight in the overall production and the high growth rates evidenced in this sector. Since some years earlier, the annual growth of this sector has fluctuated around 10-15 percent, making this sector be the first in the list of economy sectors for development.
Nonetheless, direct and indirect indexes of this sector’s output indicate that further progress requires a broader attention, particularly to a better allocation of financial, private or public resources. Construction developments in recent years, particularly their extreme concentration on certain territories, prove the lack of efficiency of urban development vision, not guaranteeing long-term sustainability of the branch. Furthermore, construction is still dominated by housing building, lagging behind all other strategic items, such as investments in road infrastructure, and other investments directly related to the standard of living of small urban and rural communities.
Box 1. Opinions on housing prices in Tirana
Nowadays there is accepted the negative impact, which has a bubble effect, of real estate prices on the economic growth. The rapid price rise of houses, not justified by basic economic factors, may lead to inappropriate investments, which will reduce the economy efficiency. The house price, likewise the price of any other asset, influences significantly on the production and inflation in the economy, because when the house price go up, the expectations on their future performance are positive. Such a fact will encourage the increased demand. Also, a higher house price increases the wealth of the individuals, encouraging consumption rise and in consequence, even the aggregate demand.
Recently, in Albania, more and more discussions are taking place on rapid price rise of apartments. To study the developments in real estate market and particularly, taking into account the lack of official statistics on this performance, in mid 2006 the BoA carried out a survey on price performance in Tirana house market. 16 real estate agencies, 12 construction firms and 17 commercial banks participated in this survey. The following came out:
In the real estate market, the main factor having caused the price rise on the supply side is the reduction of building areas and the land price are of an above- average, having influenced the price rise on the supply side. Essential factors that encourage the demand for living apartments are the increasing demand for house, driven also by demographic movements, the increased preference to invest in long-term periods and increased household incomes (particularly those of emigrants).
Most of current transactions for house purchase are based on individual savings. Also the emigrants’ remittances contribute on average by 30 percent to financing the house purchases. Most of sale transactions are carried out in euro, above 90 percent of the cases. Even when payment is made in Lek, the value of house is quoted in euro. Concerning the way the payment is done, the agencies underline that paying by installments represent about 53 percent of the cases, while the rest is made in the form of a down payment.
Now days, a considerable part of real estate purchases is financed by the banking system. Most of market stakeholders are of the opinion that bank loans increased in last 2-3 years. Real estate loans extended by the banking system usually constitute 80 percent of the collateral value. All the banks of the system use the market value approach for evaluating the collateral. Also banks apply fixed and variable interest rates for mortgage loans.
Together services and contraction count for more than 2/3 of the GDP.
Strong domestic demand supported by total factor productivity improvements and remittances has sustained high growth rates during the whole transition period. According to Country Economic Memorandum (WB, 2005) growth accounting analysis in the period 1993-2003 TFP1) growth was mainly the result of resource reallocation from low productivity sectors (agriculture, industry) to high productivity ones (services, construction). However, according to the same reportAlbania needs to identify other sources of growth to sustain the high rates of growth experienced thus far, such as enhancing capital accumulation and increasing exports.
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The fiscal posture has improved continuously. The size of budget deficit (including grants) was reduced from 10 percent to GDP before 1999 to 3.2 percent in 2006.An ongoing reform to reduce the size of
informal economy, which is estimated to be one of the biggest in the region, is expected to increase tax revenues further.
The efforts have also reduced debt-to-GDP ratios to just below 55 percent of GDP (Fig.5). But the debt, which is largely domestic, has a short maturity profile and a narrow investor hold base, creating rollover risks.
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1) Total Factor Productivity (TPF) growth is measured as a residual, total output growth less the weighted sum of input growth, known as “Solon residual”.
Fig.5 Public Debt as a % of GDP Source: BoA
Albania has been characterized by large current account deficit throughout the transition period (Fig. 6). Imports have steadily grown reaching 47 percent of GDP in 2007 with exports covering behind at 23 percent of GDP, leaving Albania with a trade deficit of 24 percent.
Albania’s receipts from migrant remittances are, relative to GDP,
among the highest in the world. Remittances are considerably larger than exports (1.2 times – Sep.07) and represent 14 percent of GDP.Although the volumes of remittances are still sent through informal channels, the importance of the formal channel has increased in recent years (Fig.7).
Fig.6 Current Account Balance, 1996-’06 (% of GDP) Source: BoA
Fig.7 Distribution of Remittances 1994-’04
Source: IOM (International Organization of Migration)
Foreign Direct Investments (FDI) remain low at 3-4 percent of GDP to fill the remaining current account gap which so far has been largely covered with grant and soft loans. While, long run sustainability issues of current accounts may occur, if certain measures that make better the competitiveness of Albanian exports and attract more FDI, are not undertaken.
2. Reasons that pushed Albania to Inflation targeting
After bringing inflation down from 237 percent in 1992 to just 6 percent in 1996, inflation has fluctuated around 3-4 percent (with the exception of the limited period after the collapse of pyramid schemes). McNeilly, et al. (1998) attributes the success of Albania in achieving low inflation to the early price liberalization …and an early aggregate supply increase in goods and services alongside a restrictive monetary policy implemented by the Bank of Albania (BoA).
As far as monetary aggregates do not contain all the necessary information to predict future inflation, relying on a monetary targeting regime could be suboptimal. (?)
Albania has been one of the few countries to have endorsed a monetary targeting regime.
Such a regime was appropriate for the framework of Financial Programming upon which the IMF technical assistance programs were based. The monetary targeting aimed to control the money offer in the economy by monitoring M3 as an intermediate target.
In compliance with the formal framework of programs supported by the IMF, the monetary targeting was accompanied by quantitative objectives (minimum) of the net international reserve, of net internal means of BoA (maximum) and of the total funding of the budget deficit (ceiling). Such limitations, in addition to being part of the limitations of the IMF programs became operational objectives of BoA through which it would be aimed to achieve control of the monetary supply.
Initially, the central bank relied on direct instruments in conducting monetary policy. The supply of broad money (M3) was controlled by ceilings imposed on the level of credit extended by commercial banks.
Later on in 1995, the interest rates of State Owned Banks’ deposits (SOBs) were also managed in a first move to switch to indirect instruments. In 1999 credit ceilings were removed, and from 2000 the central bank (BoA ) tries to influence interest rates only through open market operations in T-bills (Repos).
Although the regime has been rather successful in terms of price stability, it would not be entirely correct to attribute the success only to this regime. According to Estella and Mishkin (1997), as inflation is brought under control the informative role of monetary aggregates diminishes because the velocity shocks’ relative noise increases. This, according to them, could be an important reason why industrial countries and many emerging market economies do not rely on monetary targeting in the era of price stability.
The velocity shocks could be attributed to the instability of money demand which increases as structural changes of the financial system advance.
Albania does not make an exception from the rule. Table 1) shows the targeted and actual growth rates of the broad money (M3) and inflation.
It is evident that the actual growth rates of M3 until 2000 have diverged widely from the targets. On the contrary, inflation objective during the same period has been most of the time undershot. Even after the year 2000 when M3 growth rates have been fairly close to the targets, they have varied widely, from 5 to 13 percent, compared to the relatively stable inflation rates.
This raises doubts about the relative significance of the nominal anchor used in achieving low levels of inflation and makes it very difficult to clearly transmit the intentions of the central bank by simply announcing M3 growth targets.
Furthermore, the velocity of M3 has demonstrated a relatively high fluctuation that makes M3 an unpractical indicator in the implementation of the monetary policy. Although the annual growth of the M3 may retain the forecasting capacity, in long term periods of time it is not sufficient to serve on due time to the decision – making relevant to the monetary policy.
Consequently, BoA has to look at other possibilities and alternatives of using the information that may serve to implement on due time the monetary policy.
The central bank has been aware of this divergence and in practice decisions on changing the monetary policy have been taken based on a wider range of information besides the M3 growth, such as: inflationary pressures coming from exchange rates movements, price changes in different markets, including foreign markets, supply shocks, etc.
The experience of transition countries does not provide a clear answer on the choice of an optimal regime of the monetary policy. The best possible conclusion is that the choice should be based on a careful assessment of the specific conditions of the economy and that this choice should be combined with other macroeconomic policies. Sustainability of the overall price level in the recent years gives to BoA the alternative to follow a monetary policy in the form of monetary targeting. While the implementation of the monetary policy is oriented towards targeting of the liquidity level in the market and towards the policy of interest rates in function of keeping inflation low, BoA has maintained flexibility of the response on time towards internal macroeconomic shocks, an example of which was the massive withdrawal of deposits in 2002 (see annual report of BoA, 2002)
This way of running monetary policy to some level resembles that of inflation targeting. BoA makes public at the end of each year level of inflation aimed, which led Stone (2003) to classify Albania as an inflation targeting lite country as compared to a full fledged IT country (see Table 2).
However, there are two important elements that distinguished Albania from trained and experienced Inflation Targeting regimes: These are the communication of monetary policy strategy including the publication and explanation of its inflation forecast and a formal mechanism that makes BoA accountable to the announced inflation target.
Table 2 Inflation targeting Lite
Box. 2- Alternative regimes
The other alternatives to inflation and monetary targeting are exchange rate pegging and the so called “just do it” policy applied by FED (Mishkin, 2002). Exchange rate pass-through in Albania is thought to be high, though asymmetric, given the large proportion of imported goods in consumer basket (approx. 70 percent).This would make this regime an effective way of conducting monetary policy.
The relation of prices to the exchange rate was studied with interest during ’60-’70-s. Initially models were established that based on the theory “Law of one price” presumed the existence of a unitarian connection between them. Later on there were developed models of the Parity of Buying Power (absolute and relative) that were used to identify variations in exchange rates. However, numerous empirical tests did not support these suppositions, bringing about the idea that fluctuations in exchange rate are not completely reflected in the level of prices of a country (incomplete pass-through of the exchange rate). Now there are many models/theories that explain why this conduction/conveying) is incomplete. Recently, many empirical studies have testified that in addition to being incomplete, this transmission is also in decline.
In literature we meet “first level” pass–through that refers to the sensitivity of import prices in a country towards the variations in the exchange rate of the currency of that country and “second level” pass–through that refers to the sensitivity of consumer prices towards variations in the import prices
Nevertheless, many studies do not distinguish between these two stages, including the definition of the effect of the exchange rate fluctuations both the effect in the import prices and in the CPI.
Literature on monetary policy in Albania has often considered the channel of exchange rate as the most important one for explaining inflation developments in Albania (Muço et al, 2004). Considering the importance of the exchange rate in a small and open economy as is the Albanian economy, the central bank did neglect the developments in the exchange rate of lek.
Such literature has observed that the change in the relation between the exchange rate and inflation after 2000 (Peeters, 2005) where pass–through of the exchange rate with the consume prices in Albania are shown to be in decline.
Most of exchange rate discussions, however, refer to scenarios of controlling depreciation to curb higher inflation. From some time, Albania like several other transition countries has experienced appreciation of its currency instead. This has helped easing inflationary pressures. This has pushed BoA to occasionally intervene in the market and to reduce the local currency interest rates against the euro. However, it remains unclear whether this appreciation is a return to some kind of long term equilibrium supported by fundamental changes. This shows that exchange rate developments cannot be ignored that easily in monetary policy decision even if committed to the free floating regime.